Today’s SEC Examination Priorities, Tomorrow’s SEC Enforcement Actions – Finance and Banking


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Rounding out a series of quarter-end announcements from the US
Securities and Exchange Commission (SEC), the Division of
Examinations (Exams) announced its 2022 examination priorities
on March 30, 2022. These priorities reflect SEC Chair Gary
Gensler’s stated view that the examinations program is
crucial to the SEC’s work to protect investors and instill
trust in markets. Exams will focus on, among other things, (i)
private funds, (ii) broker-dealers, (iii) Environmental, Social,
and Governance (ESG) or impact investing, (iv) financial technology
(FinTech) and crypto-assets, and (v) information security (InfoSec)
and operational resiliency. In addition, a week before the 2022
examination priorities were announced, Richard Best was appointed
as Exams’ new Acting Director. Mr. Best most recently served
as the SEC’s Regional Director in New York after serving in
similar roles in Salt Lake City and Atlanta, where he led both the
examination and enforcement efforts of those three Regional
Offices. We expect that the number of referrals from Exams to the
Division of Enforcement (Enforcement) is likely to increase, as
today’s Exams priorities are a likely preview of
tomorrow’s Enforcement actions.

Private Funds: Exams observed that more than
5,000 registered investment advisers (RIAs) manage roughly $18
trillion in private fund assets in strategies that include hedge
funds, private equity funds, and real estate funds, whose investors
include state and local pensions, family beneficiaries, charities,
and endowments. In light of the size, complexity, and growth of
this market, Exams will focus on various issues under the
Investment Advisers Act of 1940, including (i) fiduciary duties,
(ii) compliance with the Custody Rule, (iii) disclosure and
compliance for cross trades, principal transactions, and distressed
trades, and (iv) conflicts around liquidity, such as RIA-led fund
restructurings. Exams intends to review advisers’ conflicts
and disclosures around portfolio strategies, risk management, and
investment recommendations and allocations, including investments
in Special Purpose Acquisition Companies (SPACs) and particularly
where the private fund adviser is also the SPAC sponsor. Exams also
will review all aspects of trading for private funds with indicia
of systemic importance, such as outsized counterparty exposure or
gross notional exposure when compared to similarly situated
firms.

Broker-Dealers: Exams will continue to focus on
broker-dealer activity involving microcap, municipal, fixed income,
and over-the-counter securities, as well as broker-dealer
operations. Exams also will monitor broker-dealer sales practices
and consistency with Regulation BI, particularly related to SPACs,
structured products, leveraged and inverse exchange traded products
(ETPs), real estate investment trusts (REITs), private placements,
annuities, municipal and other fixed income securities, and
microcap securities. In addition, Exams will monitor broker-dealer
compliance with the locate requirement of Regulation SHO, penny
stock disclosure rules, monitoring for and reporting of suspicious
anti-money laundering (AML) activity, and compliance with the
safeguards of the Customer Protection Rule and the Net Capital Rule
by firms that hold customer cash and securities. Exams acknowledged
its continued interest in dually registered RIAs and
broker-dealers, and firms that service both brokerage customers and
advisory clients.

ESG or Impact Investing: Exams recognized that
RIAs and registered funds are increasingly offering and evaluating
investments that employ ESG strategies or criteria, and it noted
the risk that disclosures regarding portfolio management practices
could involve materially false and misleading statements or
omissions. Exams will focus on RIA and registered fund disclosures
about their approaches to ESG investing and their policies and
procedures to ensure appropriate disclosures to clients and
investors, including portfolio management processes and practices,
as well as review whether voting of client securities aligns with
ESG-related disclosures and mandates.

FinTech and Crypto-Assets: Exams observed that
RIAs are increasingly providing automated digital investment advice
to clients, which RIAs are often called
“robo-advisers,” with a continued growth in the use of
mobile apps by broker-dealers. Exams will look at the use of
developing technologies to assess whether RIAs and broker-dealers
have considered “the unique risks these activities
present” when designing their regulatory compliance programs,
and whether firms have in place the operations and controls
necessary to satisfy their regulatory obligations, representations
to clients, and the standard of conduct owed to investors. Exams
also noted “a proliferation of the offer, sale, and trading
of crypto-assets,” and advised that its review of market
participants engaged with crypto-assets will include custody
arrangements and communications in the offer, sale, recommendation,
advice, and trading of such assets. Exams indicated it will examine
mutual funds and ETFs that offer exposure to crypto-assets to
assess, among other things, compliance, liquidity, and operational
controls around portfolio management and market risk.

InfoSec and Operational Resiliency: Exams
stressed that the consequences of information security failures by
RIAs and broker-dealers may extend to other market participants and
retail investors, making “vigilant protection of data . . .
critical to the operation of financial markets and the confidence
of its participants.” Exams will continue to review
firms’ efforts to prevent interruptions to mission-critical
services, protect investor information, and safeguard customer
accounts and prevent account intrusions, both in-house and through
oversight of vendors and service providers. Exams also will review
firms’ efforts to address and respond to malicious email
activities and ransomware attacks, identify and detect red flags
related to identity theft, and manage operational risk as a result
of a dispersed workforce. In addition, Exams will review business
continuity and disaster recovery plans with a focus on the impact
of climate risk and substantial disruptions to business operations
and the maturation of the plans over the years.

The 2022 examination priorities report marks the ten-year
anniversary of Exams (previously the Office of Compliance
Inspections and Examinations) publishing its examination
priorities. As in prior years, the report provides a roadmap to
broker-dealers, RIAs, and other market participants as to the
specific areas that Exams will focus on during the coming year.
Given the strong regulatory and enforcement stance of the
SEC’s current leadership, firms would be well-advised to
study the examination priorities, review their policies and
procedures, and be prepared to address these focus areas during
upcoming examinations. Proactively ensuring compliance at the
outset will help avoid what otherwise might become an enforcement
referral in the future.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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